company case southwest airlines

Chapter 10: Pricing: Understanding and Capturing Customer Value

Chapter 10PRICING: UNDERSTANDING AND CAPTURING

CUSTOMER VALUE

CHAPTER OVERVIEW Use Power Point Slide 10-1 Here

Firms successful at creating customer value with the other marketing mix activities must capture this value in the prices they earn.

Despite its importance, many firms do not handle pricing well.

In this chapter, we begin with the question, What is a price? Next, we look at customer-value perceptions, costs, and other factors that marketers must consider when setting prices.

Price can be defined as the sum of all the values that customers give up in order to gain the benefits of having or using a product or service. Pricing decisions are subject to an incredibly complex array of company, environmental, and competitive forces.

Finally, we examine pricing strategies for new-product pricing, product mix pricing, price adjustments, and dealing with price changes.

CHAPTER OBJECTIVESUse Power Point Slide 10-2 Here

1. Answer the question “What is price?” and discuss the importance of pricing in today’s fast changing environment.

2. Discuss the importance of understanding customer value perceptions when setting prices.

3. Discuss the importance of company and product costs in setting prices.

4. Identify and define the other important external and internal factors affecting a firm’s pricing decisions.

CHAPTER OUTLINE

P. 289 INTRODUCTION

Trader Joe’s is not really a gourmet food store. Then again, it’s not a discount food store either. It’s actually a bit of both. One of America’s hottest retailers, Trader Joe’s has put its own special twist on the food price-value equation – call it “cheap gourmet.”

P. 289Photo: Trader Joe’s

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 304

Part 3: Designing a Customer-Driven Strategy and Mix

Trader Joe’s describes itself as an “island paradise” where “value, adventure, and tasty treasures are discovered, every day.” Customers don’t just shop at Trader Joe’s, they experience it.

Shelves bristle with an eclectic assortment of gourmet-quality grocery items. Trader’ Joe’s stocks only a limited assortment of about 2,000 specialty products (compared with 45,000 items found at a Safeway). However, the assortment is uniquely Trader Joe’s.

A special store atmosphere, exclusive gourmet products, helpful and attentive associates – this all sounds like a recipe for high prices. Not so at Trader Joe’s.

How does Trade Joe’s keep it gourmet prices so low? It all starts with lean operations and a near-fanatical focus on saving money. Trader Joe’s also saves money by spending almost nothing on advertising.

It’s all about value and price – what you get for what you pay.

Opening Vignette Questions1. What do you believe to be the ‘secret’ to Trader

Joe’s success?2. How does Trader Joe’s keep prices so low

(compared to Whole Foods, for example)?3. Is Trader Joe’s a gourmet store?

Assignments, ResourcesUse Web Resources 1 and 2 here

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WHAT IS A PRICE?

In the narrowest sense, price is the amount of money charged for a product or service.

More broadly, price is the sum of all the values that customers give up in order to gain the benefits of having or using a product or service.

Price is the only element in the marketing mix that produces revenue.

Price is one of the most flexible marketing mix elements.

Chapter Objective 1

P. 290Key Term: Price

P. 290Photo: Panera Bread Company

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall305


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FACTORS TO CONSIDER WHEN SETTING PRICES

Figure 10.1 summarizes the major considerations in setting price.

Customer Perceptions of Value

In the end, the customer will decide whether a product’s price is right.

Value-Based Pricing

Value-based pricing uses buyers’ perceptions of value, not the seller’s cost, as the key to pricing.

Price is considered along with the other marketing mix variables before the marketing program is set.

Cost-based pricing is product driven.

“Good value” is not the same as “low price.”

Two types of value-based pricing are good-value pricing and value-added pricing.

1. Good-Value Pricing. Good-value pricing is offering just the right combination of quality and good service at a fair price.

Everyday low pricing (EDLP). EDLP involves charging a constant, everyday low price with few or no temporary price discounts.

High-low pricing involves charging higher prices on an everyday basis but running frequent promotions to lower prices temporarily on selected items.

2. Value-Added Pricing. Value-added pricing is the strategy of attaching value-added features and services to differentiate their offers and thus support higher prices.

Chapter Objective 2

P. 291Figure 10.1: Considerations in Setting Price

P. 291Key Term: Value-Based Pricing

P. 292Photo: Bentley

P. 292Figure 10.2: Value-Based Pricing Versus Cost-Based Pricing

P. 293Key Terms: Good-Value Pricing, Value-Added Pricing

P. 293Photo: Value-Added Pricing

Assignments, ResourcesUse Real Marketing 10.1 hereUse Discussing the Concepts 1, 2 and 3 here



Use Applying the Concepts 1 hereUse Video Case hereUse Focus on Technology hereUse Additional Projects 1, 2, and 3 hereUse Individual Assignments 1 and 2 hereUse Small Group Assignment 1 hereUse Think-Pair-Share 1, 2, 3 hereUse Outside Example 1 hereUse Web Resources 3 and 4 here

Troubleshooting Tip1) Even if a few students have worked in a family

business, it is a very safe bet that none of them have ever set prices on anything. Even if they are a devotee of eBay and have been buying and selling items for years, they still won’t have set prices because of the auction environment of that and other sites that have sprung up in the years since the explosion of the World Wide Web. So, although the “What Is a Price?” section is very short, it is well worth spending some time talking about the difference between fixed-price policies and dynamic pricing. A discussion of what it’s like to buy a meal at a restaurant, where you cannot typically haggle on price, and buying a car, where you are expected to haggle on price, can drive home the difference between the two. A discussion of what has happened with auctions and exchanges online will also help.

2) Value-based pricing could engender a considerable amount of conversation, particularly if someone thinks it is unethical to charge a price for something that yields the company a very large margin. Why wouldn’t you treat customers “right” by charging them less? A discussion of the meaning of customer focus and of benefits to the customer will help the class to understand that if the customer thinks he is getting value, he will happily pay the price.

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Company and Product Costs

Cost-based pricing involved setting prices based on the costs for producing, distributing, and selling the product plus a fair rate of return for its effort and risk.

Chapter Objective 3

P. 295Key Terms: Cost-Based Pricing,



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Types of Costs

Fixed costs (also known as overhead) are costs that do not vary with production or sales level.

Variable costs vary directly with the level of production. They are called variable because their total varies with the number of units produced.

Total costs are the sum of the fixed and variable costs for any given level of production.

Costs at Different Levels of Production

To price wisely, management needs to know how its costs vary with different levels of production.

Figure 10.3A shows the typical short-run average cost curve (SRAC).

Figure 10.3B shows the long-run average cost curve (LRAC).

Average cost tends to fall with accumulated production experience. This is shown in Figure 10.4 (P. 309). This drop in the average cost with accumulated production experience is called the experience curve (or the learning curve).

A single-minded focus on reducing costs and exploiting the experience curve will not always work. The aggressive pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company’s price cuts. Finally, while the company is building volume under one technology, a competitor may find a lower-cost technology that lets it start at prices lower than those of the market leader, who still operates on the old experience curve.

Cost-Based Pricing

The simplest pricing method is cost-plus pricing—adding a standard markup to the cost of the product.

Does using standard markups to set prices make sense? Generally, no.

Fixed Costs (Overhead)

P. 296Key Terms: Variable Costs, Total Costs

P. 296Figure 10.3: Cost Per Unit at Different Levels of Production Per Period

P. 296Key Term: Experience Curve (Learning Curve)

P. 297Figure 10.4: Cost Per Unit as a Function of Accumulated Production: The Experience Curve

P. 297Key Term: Cost-Plus Pricing



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Markup pricing remains popular for many reasons.

1. Sellers are more certain about costs than about demand.

2. When all firms in the industry use this pricing method, prices tend to be similar and price competition is thus minimized.

3. Many people feel that cost-plus pricing is fairer to both buyers and sellers.

Break-Even Analysis and Target Profit Pricing

Another cost-oriented pricing approach is break-even pricing, or a variation called target profit pricing. The firm tries to determine the price at which it will break even or make the target profit it is seeking.

Target pricing uses the concept of a break-even chart that shows the total cost and total revenue expected at different sales volume levels. Figure 10.5 shows a break-even chart.

The manufacturer should consider different prices and estimate break-even volumes, probable demand, and profits for each. This is done in Table 10.1.

P. 298Key Term: Break-Even Pricing (Target Profit Pricing)

P. 298Figure 10.5: Break-Even Chart for Determining Target Price

P. 299Table 10.1: Break-Even Volume and Profits at Different Prices

Assignments, ResourcesUse Discussing the Concepts 4 hereUse Additional Projects 4 hereUse Think-Pair-Share 4 and 5 here

Troubleshooting TipStudents may need further explanation regarding why cost-based pricing isn’t the right way to price everything. It’s simple, it’s easy to apply a formula, and there is no guesswork involved. You need to drive home the point that it ignores the customer completely—cost-based pricing is internally focused, without a thought to the demand parameters or competitors’ prices. You can talk about this from the perspective of a high-cost manufacturer—how much would they be able to sell if their product cost 50% more than the competition simply because the



company hadn’t figured out how to manufacture it effectively?

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Other Internal and External Considerations Affecting Price Decisions

Overall Marketing Strategy, Objectives, and Mix

General pricing objectives might include survival, current profit maximization, market share leadership, or customer retention and relationship building.

Price is only one of the marketing mix tools that a company uses to achieve its marketing objectives.

Price decisions must be coordinated with product design, distribution, and promotion decisions to form a consistent and effective integrated marketing program.

Companies often position their products on price and then tailor other marketing mix decisions to the prices they want to charge.

Target costing starts with an ideal selling price based on customer-value considerations, and then targets costs that will ensure that the price is met.

Companies may deemphasize price and use other marketing mix tools to create nonprice positions.

Organizational Considerations

In small companies, prices are often set by top management rather than by the marketing or sales departments.

In large companies, pricing is typically handled by divisional or product line managers.

In industrial markets, salespeople may be allowed to negotiate with customers within certain price ranges.

In industries in which pricing is a key factor, companies often have pricing departments to set the best prices or to help others in setting them.

Chapter Objective 4

P. 300Key Term: Target Costing

P. 300Ad: Titus



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The Market and Demand

Pricing in Different Types of Markets.

Pure competition: The market consists of many buyers and sellers trading in a uniform commodity. No single buyer or seller has much effect on the going market price.

In a purely competitive market, marketing research, product development, pricing, advertising, and sales promotion play little or no role. Thus, sellers in these markets do not spend much time on marketing strategy.

Monopolistic competition: The market consists of many buyers and sellers who trade over a range of prices rather than a single market price. A range of prices occurs because sellers can differentiate their offers to buyers.

Oligopolistic competition: The market consists of a few sellers who are highly sensitive to each other’s pricing and marketing strategies.

There are few sellers because it is difficult for new sellers to enter the market.

Pure monopoly: The market consists of one seller. The seller may be a government monopoly, a private regulated monopoly, or a private nonregulated monopoly.

P. 302Ad: Kohler

Assignments, ResourcesUse Real Marketing 10.2 hereUse Discussing the Concepts 5 and 6 hereUse Focus on Ethics hereUse Additional Projects 5 hereUse Outside Example 2 hereUse Web Resources 5 here

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Analyzing the Price-Demand Relationship.

The relationship between the price charged and the resulting demand level is shown in the demand curve (Figure 10.6).

In the case of prestige goods, the demand curve sometimes slopes upward. Consumers think that higher prices mean

P. 303Key term: Demand Curve

P. 303Figure 10.6:



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more quality.

In a monopoly, the demand curve shows the total market demand resulting from different prices.

If the company faces competition, its demand at different prices will depend on whether competitors’ prices stay constant or change with the company’s own prices.

Price Elasticity of Demand.

Price elasticity is how responsive demand will be to a change in price.

If demand hardly changes with a small change in price, we say demand is inelastic.

If demand changes greatly with a small change in price, we say the demand is elastic.

Competitors’ Strategies and Prices

In assessing competitors’ pricing strategies, the company should ask several questions.

1. How does the company’s market offering compare with competitors’ offerings in terms of customer value?

2. How strong are current competitors and what are their current pricing strategies?

3. How does the competitive landscape influence customer price sensitivity?

Other External Factors

Economic conditions can have a strong impact on the firm’s pricing strategies.

The company must also consider what impact its prices will have on other parties in its environment, such as resellers and the government.

Social concerns may have to be taken into account.

Demand Curve

P. 304Key Term: Price Elasticity

P. 303Ad: Gibson Guitars

P. 305Ad: Annie Bloom’s Books

Assignments, ResourcesUse Applying the Concepts 2 and 3 here



Use Marketing by the Numbers hereUse Company Case hereUse Small Group Assignment 2 hereUse Web Resources 6 here

END OF CHAPTER MATERIAL

Discussing the Concepts

1. What is price? List five other words that mean the same thing as price (for example, tuition). (AACSB: Communication; Reflective Thinking)

Answer:

In the narrowest sense, price is the amount of money charged for a product or service. More broadly, price is the sum of all the values that customers give up in order to gain the benefits of having or using a product or service. Examples of other terms used for price are rent, fee, rate, tax, toll, commission, and assessment.

2. Explain the differences between value-based pricing and cost-based pricing. (AACSB: Communication)

Answer:

Cost-based pricing is product driven. The company designs what it considers to be a good product, adds up the costs of making the product, and sets a price that covers costs plus a target profit. Marketing must then convince buyers that the product’s value at that price justifies its purchase. If the price turns out to be too high, the company must settle for lower markups or lower sales, both resulting in disappointing profits.

Value-based pricing reverses this process. The company first assesses customer needs and value perceptions. It then sets its target price based on customer perceptions of value. The targeted value and price then drive decisions about what costs can be incurred and the resulting product design. As a result, pricing begins with analyzing consumer needs and value perceptions, and price is set to match consumers’ perceived value.

3. Name and describe the two types of value-based pricing methods. (AACSB: Communication)

Answer:

There are two types of value-based pricing: good-value pricing and value-added pricing. Good-value pricing strategies offer just the right combination of quality and good service at a fair price. In many cases, this has involved introducing less-expensive versions of established, brand name products. In other cases,



good-value pricing has involved redesigning existing brands to offer more quality for a given price or the same quality for less. An important type of good-value pricing at the retail level is everyday low pricing (EDLP). EDLP involves charging a constant, everyday low price with few or no temporary price discounts. To increase their pricing power, many companies adopt value-added pricing strategies. Rather than cutting prices to match competitors, they attach value-added features and services to differentiate their offers and thus support higher prices.

4. Compare and contrast fixed and variable costs and give an example of each. (AACSB: Communication)

Answer:

Fixed costs (also known as overhead) are costs that do not vary with production or sales level. For example, a company must pay each moth’s bills for rent, heat, interest, and executive salaries, whatever the company’s output. Variable costs vary directly with the level of production. Each product manufacturer involves costs related to raw materials and parts. These costs tend to be the same for each unit produced. They are called variable because their total varies with the number of units produced.

5. Discuss other internal and external considerations besides cost and customer perceptions of value that affect pricing decisions. (AACSB: Communication)

Answer:

Internal factors affecting pricing include the company’s overall marketing strategy, objectives, and marketing mix, as well as other organizational considerations such as who within the organization should set prices.

External factors include the nature of the market and demand, competitors’ strategies and prices, and other environmental factors.

6. Name and describe the four types of markets recognized by economists and discuss the pricing challenges posed by each. (AACSB: Communication)

Answer:

Economists recognize four types of markets, each presenting different pricing challenges:



Pure competition: the market consists of many buyers and sellers trading in a uniform commodity such as wheat, copper, or financial securities. No single buyer or seller has much effect on the going market price. A seller cannot charge more than the going price, because buyers can obtain as much as they need at that price. Nor would sellers charge less than the market price, because they can sell all they want at this price. Marketing activities play little or no role.

Monopolistic competition: the market consists of many buyers and sellers who trade over a range of prices rather than a single market price because sellers can differentiate their offers to buyers. Buyers see differences in sellers’ products and will pay different prices for them.

Oligopolistic competition: the market consists of a few sellers who are highly sensitive to each other’s pricing and marketing strategies. There are few sellers because it is difficult for new sellers to enter the market. Each seller is alert to competitors’ strategies and moves and responds to each others’ changes in price.

Pure monopoly: the market consists of one seller, which may be a government monopoly, a private regulated monopoly, or a private nonregulated monopoly. Pricing is handled differently in each case. In a regulated monopoly, the government permits the company to set rates that will yield a “fair return.” Nonregulated monopolies are free to price at what the market will bear. However, they do not always charge the full price for a number of reasons: a desire not to attract competition, a desire to penetrate the market faster with a low price, or a fear of government regulation.

Applying the Concepts

1. In a small group, discuss your perceptions of value and how much you are willing to pay for the following products: automobiles, frozen dinners, jeans, and athletic shoes. Are there differences among members of your group? Explain why those differences exist. Discuss some examples of brands of these products that are positioned to deliver different value to consumers. (AACSB: Communication; Reflective Thinking)

Answer:

Students’ responses will vary because perceptions of value vary among consumers. For example, some consumers think of athletic shoes as shoes to wear when not wearing dress shoes or sandals and will not pay more than $30 or $40 for a pair. Keds might be an example of a brand delivering this level of value to consumers. However, some see the value in shoes that are designed for specific sports and are willing to pay more than $100 for a pair. Nike, New Balance, and Asics could be brands delivering this value to consumers. Others may see the fashion value in some athletic shoes and are willing to pay higher prices. Puma and K-Swiss are brands that might deliver this value to consumers.

2. Find estimates of price elasticity for a variety of consumer goods and services. Explain what price elasticities of 0.5 and 2.4 mean (note: these are absolute values, as price elasticity is usually negative). (AACSB: Communication; Reflective Thinking)



Answer:

Students’ responses will vary depending on the source used to collect this information. One useful Web site listing price elasticities of several consumer goods and services is http://www.mackinac.org/article.aspx?ID=1247. Some examples of inelastic demand include salt (0.1), gasoline (0.2), coffee (0.25), and physician services (0.6). Examples of approximately unitary elasticity include movies (0.90) and private education (1.1). Examples of elastic demand include restaurant meals (2.3), foreign travel (4.0), and automobiles (1.2-1.5).

A price elasticity of 0.5 represents inelastic demand, which means the percentage change in quantity demanded is less than the percentage change in price. The less elastic the demand, the more it pays for the seller to raise the price. A price elasticity of 2.5 is elastic, meaning the percentage change in quantity demanded is greater than the percentage change in price.

3. What does the following positioning statement suggest about the firm’s marketing objectives, marketing-mix strategy, and costs? “No one beats our prices. We crush the competition.” (AACSB: Communication; Reflective Thinking)

Answer:

This firm has adopted a low-price leader position, and a logical marketing objective would be to gain share and maintain market share leadership. It relies heavily on price and less so on the three other elements of the marketing mix. It is probably the low cost provider and as a result is able to sustain its “No one beats our prices” position.

Focus on Technology

It seems a day doesn’t go by without some talk about gas prices. Consumers are more keenly aware of the price now that it costs $40 to $100 to fill up the tank. And many consumers are using technology to help find the lowest prices in their area. The Internet is making it much easier to get price comparisons from Web sites such as GasBuddy.com (www.gasbuddy.com) and GasPriceWatch.com (www.gaspricewatch.com). These sites give price information on maps for a consumer’s zip code area. Consumers can download programs, called widgets, which continually update this information on users’ computers. If you’re not at your computer, you can get this information on your cell phone from www.getmobio.com/learn/cheapgas/. Most of the Web sites rely on volunteers to update prices.

1. Visit some of these Web sites and evaluate their usefulness to consumers. Recommend some other applications that would enable consumers to find the best gas prices. (AACSB: Communication; Use of IT; Reflective Thinking)

Answer:


http://www.getmobio.com/learn/cheapgas/

http://www.gaspricewatch.com/

http://www.gasbuddy.com/

http://www.mackinac.org/article.aspx?ID=1247


Students’ perceptions of the usefulness of these Web sites will vary. For example, when searching a particular zip code on GasPriceWatch.com, only four of the several gas stations had price information, and it was more than 72 hours old. Trying to find more recent information resulted in “???” for price results for all stations, indicating that no data that recent were available. Using GasBuddy.com didn’t have all of the gas stations in an area and the map gave irrelevant information. For example, clicking on “map” for one of the Shell stations gave location information for any business with the name “Shell,” such as Shell Chiropractic Clinic. All of these sites rely on volunteers to update prices. An example of another application is for consumers to get this type of information on navigation systems in their automobiles.

2. Why are consumers so concerned about the price of gas and why are they willing to search out stations with lower prices? (AACSB: Communication; Reflective Thinking)

Answer:

Students’ answers’ will vary. However, this is a good product to use when discussing price elasticity. Demand for gasoline is inelastic. Most consumers still need to go about their daily lives regardless of the price of fuel, and there are few substitutes. In many localities, mass transit alternatives are limited. Choices for alternative-fuel automobiles are nonexistent or limited and switching costs are high. However, consumers are concerned about it and are willing to seek out the lowest prices within their geographic areas because many view gasoline as a commodity. Many consumers do not see value differences among the different brands of gasoline, so switching behavior is common.

Focus on Ethics

You’ve heard of a monopoly, but have you ever heard of a monopsony? A monopsony involves one powerful buyer and many sellers. The buyer is so powerful that it can drive prices down. An example is Wal-Mart, the world’s largest retailer. Wal-Mart’s power allows it to get the lowest possible prices from its suppliers. Similarly, wine-making giant E. & J. Gallo has so much power buying grapes that growers have to concede to the wine maker’s demands for lower prices.

1. Is it fair that a buyer can exert so much power over a supplier? Are there any benefits to consumers? (AACSB: Communication; Ethical Reasoning)

Answer:

Some students will argue that it is the free market working and is inherently fair. However, whereas larger suppliers can meet the demands of the powerful buyer, smaller suppliers will not be able to compete. This may not be in the best interests of consumers if it reduces competition or if product quality suffers. However, the lower prices will be passed on to consumers, so some will argue that it is good for consumers. For example, Wal-Mart leverages its buying power to obtain lower prices, which it in turn passes on to consumers in the form of lower prices.



2. Should the government step in and set minimum price levels? Discuss the consequences of your answer. (AACSB: Communication; Reflective Thinking)

Answer:

Students’ responses will vary. Some students will argue that government intervention is necessary to protect the small suppliers. With minimum price levels set by the government, the smaller firms may be able to compete with the larger suppliers. However, consumers may be hurt if suppliers must sell at a minimum price, resulting in higher prices for consumers.

Marketing by the Numbers

One external factor manufacturers must consider when setting prices is reseller margins. Manufacturers do not have the final say concerning the price to consumers—retailers do. So, manufacturers must start with their suggested retail prices and work back, subtracting out the markups required by resellers that sell the product to consumers. Once that is considered, manufacturers know at what price to sell their products to resellers, and they can determine what volume they must sell to breakeven at that price and cost combination. To answer the following questions, refer to Appendix 2, Marketing by the Numbers.

1. A consumer purchases a flat iron to straighten her hair for $150 from a salon at which she gets her hair cut. If the salon’s markup is 40 percent and the wholesaler’s markup is 15 percent, both based on their selling prices, for what price does the manufacturer sell the product to the wholesaler? (AACSB: Communication; Analytical Reasoning)

Answer:price cost

Markup percentage on price = —————— price

so,Cost at each level = price (price markup%)

The retailer’s cost = $150 ($150 0.4) = $90, which is the price the wholesaler sells it to the retailer.

The wholesaler’s cost = $90 ($90 0.15) = $76.50, which is the price the manufacturer sells the product to the wholesaler.

Another way to compute this is:

Retail price: $150.00minus retail margin (40%): $ 60.00

Retailer’s cost/wholesaler’s price: $ 90.00minus wholesaler’s margin (15%): $ 13.50

Wholesaler’s cost/manufacturer’s price $ 76.50



2. If the unit variable costs for each flat iron are $40 and the manufacturer has fixed costs totaling $200,000, how many flat irons must this manufacturer sell to breakeven? How many must it sell to realize a profit of $800,000? (AACSB: Communication; Analytical Reasoning)

Answer: Fixed cost

Breakeven volume = ———————— Price – Variable Cost

So,

$200,000Breakeven volume = ——————— = 5,479.45 or 5,480 flat irons $76.50 – $40

If the manufacturer wants to realize a $200,000 profit, then this amount is added to the fixed costs in the numerator:

$200,000 + $800,000Breakeven volume = ———————— = 27,397.28 or 27,398 flat irons

$76.50 – $40

Company Case Notes

Southwest Airlines: Staying Ahead in the Pricing Game

Synopsis

This case provides an in-depth look at why Southwest Airlines was by all measures the most successful airline in the U.S. Southwest had devised a business model based on low costs and low prices. But that model also included very reliable and personable service. With such a winning combination, its no wonder that Southwest consistently did what no other airline company could: it turned a profit.

When something works, you stick with it. Southwest did just that, changing its strategy very little. But all good things come to an end. As market conditions began to change, it became very apparent that Southwest would not be able to maintain its advantage based on the same model it had been employing. So in 2004, Gary Keller, the newly crowned CEO, made some very significant changes to Southwest’s game plan.

This case outlines that nature of Southwest original business plan as well as the changes implemented during and after 2004. In both cases, the focus is on how Southwest implemented pricing policy. The contrast provides an excellent opportunity for students to consider whether or not the changes are changes in the right direction.

Teaching Objectives

The teaching objectives for this case are to:



1. Allow students to understand how a firm’s marketing objectives and marketing mix strategy affect its pricing decisions.

2. Help students understand the nature of costs in the airline industry and how the relationship of fixed and variable costs affect marketing decisions.

3. Enable students to understand how the nature of a market and market demand affect pricing decisions.

4. Let students examine the pricing approaches airlines have used.5. Allow students to make pricing and other marketing recommendations for Southwest.

Discussion Questions

1. What has been Southwest's traditional pricing strategy? Why has this pricing strategy been so successful throughout the airline’s first three decades?

Southwest has historically and relentlessly pursued a low-price strategy. Its goal was to always be the cheapest carrier in any market where it flew. This would ultimately require the competing carriers to drop their prices to match those of Southwest in order to be competitive. This is something that has come to be known as the “Southwest Effect”.

The easy answer to why it worked is based on Southwest’s cost structure. The business plan that Herb Kelleher developed seemed to fly in the face of every aspect of airline convention. No meals, no assigned seats, no amenities, no retirement plan, one kind of plane, and flying point-to-point instead of hub-and-spoke. But every one of these things were cheaper for Southwest and gave it a cost advantage. Thus, when competition attempted to match Southwest’s prices, they could not match Southwest’s profits.

Students should recognize that in order to deliver low prices, Southwest must keep the cost of the other marketing mix variables low. Thus, it offers a no-frills, point-to-point, air transportation service (product) at out-of-the-way airports (places) where costs are low, with limited and low-cost promotion. Price is the only marketing mix variable that produces revenue, so with low prices the company must keep the cost of the other variables low. Southwest has done an excellent job of getting the marketing mix variables to fit with each other.

But the rest of why this strategy worked for Southwest has to do with consumers and their perceptions of value. This is addressed in the next question.

2. What values do airline customers—both business and leisure travelers—seek when they buy air travel tickets? Has Southwest done a better job than competitors of meeting the needs of these air travelers? In what ways?

Students should recognize that there is more than one kind of airline traveler and that each values different things. Some examples include the following.

Leisure travelers



Low prices Friendly service On-time performance Accurate baggage handling

Business travelers Flexible scheduling Reserved seating First class options Meals Entertainment (movies, music) Larger, roomier planes Frequent flyer points Frequent flyer clubs On-time performance Accurate baggage handling

The bottom line is, leisure travelers may have very well enjoyed the perks and amenities offered by other airlines. But at what cost? The thing that they valued the most was getting from point A to point B as cheaply and effectively as possible. They would gladly trade a meal and a movie for a lower price. Southwest recognized this and focused on serving this target segment.

As this question is discussed, it may be helpful to put weights next to the different benefits for each target segment. The interesting thing to note is that there are definitely benefits that the business traveler seeks (on-time performance, accurate baggage handling) that Southwest delivers better than any of the competition.

3. What internal and external factors affect airline pricing decisions? What impact are these factors now having on airline pricing and profitability?

These are key questions for the students to understand. It is helpful to ask students to think about which costs are fixed and which are variable in the airline business. Students should quickly see that all the salaries of the pilots, flight attendants, ground crews, terminal personnel, reservations systems personnel, and corporate employees are all fixed. The costs of the planes, the gates at the airports, terminal fees, etc., are also fixed. The only variable costs are the transaction costs of issuing a ticket (very low with e-tickets), the extra fuel the plane uses because of the extra weight of the passenger and luggage, and any in-flight food or beverages. The true variable cost of flying one additional passenger is very low.

So, students should see that air transportation is a very high fixed-cost business. In such a business, volume is important. The unit price minus unit variable cost (unit contribution) is high. An airline must have a high volume of passengers to cover the high fixed costs. Operating below break-even volume results in an airline losing lots of money quickly. Operating above break-even volume results in an airline making lots of money



quickly. This is why the airlines can have lots of sales promotions and discounts—they had rather have a passenger in a seat making some unit contribution than have that seat be empty and produce no unit contribution. In this type of business, a company varies its pricing to produce the volume it needs. The text discusses dynamic pricing—charging different prices depending on individual customers and situations. The airline industry is an excellent example of this practice.

Students should also see from the information in the case that the older airlines, like US Airways, have very different cost structures from the newer entrants. Not only do they have pilots, flight attendants, and ground crews that may be unionized and have higher salaries, wages, and benefits, but also they may have high-cost airplanes and infrastructure. Note in the case that Southwest has an important advantage in that it has no fixed-cost pension system. Rather, it has a profit-sharing system. This converts pension cost from a fixed cost to a variable cost, significantly reducing its break-even point.

Since the year 2000, various things have changed in the industry that have affected the nature of costs. First, the costs associated with travel agencies are dropping as Internet booking services have replaced that intermediary. While this is a factor that is improving the cost structure for the legacy airlines, it is not helping Southwest at all given that they have never worked through travel agents. Second, fuel prices have gone up considerably. The nature of the fuel contracts that many airlines have, including Southwest, are changing. In some cases they may be more favorable. In Southwest’s case, they are becoming less favorable. Other things that are affecting Southwest’s structure is that it is adding amenities that it previously did not offer (satellite radio) and it is starting to provide service out of the big airports that charge higher fees.

4. What is Southwest’s current pricing strategy? Does his strategy differentiate Southwest from its competitors? Is the strategy sustainable?

Students should identify the main points of Southwest’s pricing strategy that have changed:

Price increases. We are only given the information that prices went up six times and 11.4 percent in 2006.

New pricing category. The Business Select category commanded prices of $30-$50 more than other fares.

Overall structural change. From five categories or pricing to three. The interesting thing here is that the previous system had five categories focused on non-business travelers. The current structure has only one pricing category focused on non-business travelers.

Perhaps more important than the pricing changes in this case are the required changes to the other marketing mix variables.



Targeting business travelers with preferential seating, bonus frequent-flier credits, free cocktails, and updated boarding areas with amenities.

Expanding its sales force and working directly with corporate travel managers. Joining the computer ticketing system of the travel industry.

On all these counts, the question of differentiation becomes harder to identify. Southwest is now doing many things that its competition has always done. At the same time, competitors like Jet Blue are beating Southwest at its own low-price game while at the same time offering amenities. The elements that Southwest seems to be able to hold on to in terms of differentiation are on-time performance and baggage handling.

Sustainability is a question where student opinions will differ. It is important to note that previously, Southwest’s strategy was working because it was focused on serving one target segment, and serving it well. But it got to the point where Southwest could no longer rely on that. So, it had to branch out to business travelers. Meeting the needs of both segments with one basic product is definitely going to be a challenge.

5. What marketing recommendations, including pricing recommendations, would you make to Southwest as it moves into the next decade?

Student responses will certainly vary here. But question may provide the richest opportunity for discussion on this case. Students may discuss how Southwest should position itself versus the other low-fare airlines. Southwest has a history of being entertaining. Its flight attendants often work to get the customers to laugh. At a time when flying has become more of a hassle due to security regulations, Southwest might want to emphasize that positioning. Helping its customer relax and have some fun in the midst of what can be a mentally and physically tiring trip could add value to flying Southwest.

One recommendation that students may make is that Southwest should use its promotional tools not only to communicate about its low fares but also to educate customers about what Southwest is and what it offers. Although many customers may know of or have used Southwest at a neighboring airport, many potential leisure customers will not have had that experience. Southwest wants to use these customers to expand the market. These customers may not have thought about how inexpensive it might be to fly on their next vacation or family visit. Southwest wants these people to consider flying versus driving.

Southwest’s strategy is about more than just low price. It has established a brand that promises a total experience that will be satisfying to its customers. It offers on-time departures and arrivals, friendly service, error-free baggage handling, the availability of low fares, an easy frequent-flyer program, and direct flights. Students can suggest any number of promotion ideas to communicate Southwest’s brand promise to the leisure traveler.

For the thrift-minded businessperson, students will suggest that price may be the most important factor, but the total experience will be what keeps that customer coming back



to Southwest. It may be that some businesspeople do not think about flying Southwest. So, promotions should communicate that Southwest also serves businesspeople interested in saving money. Some students may suggest that Southwest should segment the business market and target that small business owner or manager who may travel only a few times per year. There may be locally-oriented business newspapers or magazines that Southwest can use to communicate with these customers.

The case mentions that other low-fare airlines are beginning to offer some frills, such as JetBlue making Direct TV available at every seat free of additional charges. This points out the disadvantage of letting customers focus only on price. Meeting a competitor’s price may be easy. However, the company has to differentiate itself. A customer who can get a low fare and free TV may well take that offer. Southwest is going to have to deal with the issue of what it is going to do as competitors, some of whom have even lower cost structures, enter its markets with enhanced product offerings. Again, the key will be to get its customers and potential customers to see the value of the entire Southwest experience, not just the price.

Teaching Suggestions

Through the questions asked, there is plenty of opportunity for discussing various concepts from this chapter, particularly those related to costs and how costs affect the other elements of the marketing mix. One of the primary purposes of this case is to show how pricing strategy is directly tied to consumers’ perception of value. Thus, it can be used to illustrate value-based pricing. This case can also be used to illustrate price elasticity of demand and how this principle has worked both in and against Southwest’s favor. Finally, this is a case that easily bridges the two pricing chapters. Consider Southwest’s history, its original business model, and its current business model. Use this material to illustrate the appropriate pricing strategies.

This case goes well with the chapters on managing customer relationships and company strategy (Chapters 1 and 2).

ADDITIONAL PROJECTS, ASSIGNMENTS, AND EXAMPLES

Projects

1. Interview a local business about their pricing philosophy and/or strategy. Use their terms and then apply what you have learned from them to assess their approach to those described in the text. What are the similarities and differences? (Objective 2)

2. Use the local newspaper to compare grocery store ads for price specials. What can you determine about the competitors’ pricing strategies? How many of the techniques from the chapter do the organizations seem to be using? What strategy appears to be the most successful? How did you make this judgment? (Objective 2)

3. How does Wal-Mart make use of Good-Value Pricing? (Objective 2)4. Explain how companies such as Dell use Cost-Plus Pricing. What are the competitive

disadvantages of such pricing strategies? (Objective 3)



5. Take a drive around town and look at the pricing of gasoline at a variety of different stations. Use Oligopolistic Competition to explain what you are seeing. (Objective 4)

Small Group Assignments

1. Form students into groups of three to five. Each group should read Real Marketing 10.1 (p. 294). Each group should then answer the following questions and share their answers with the class. (Objective 20a. Is Ryanair utilizing an effective pricing strategy?b. How has Ryanair been able to maintain their current pricing strategy in the wake of

the turbulent air travel market?c. What is Ryanair’s position in the mind of the customer?

2. Form students into groups of three to five. Each group should read the Real Marketing 10.2 (p. 301). Each group should then answer the following questions and share their answers with the class. (Objective 4)a. Is Ferrari utilizing an effective pricing strategy?b. Besides price, what is it that makes Ferrari positioning unique?c. What pricing strategy is Stella Artois utilizing? Are they effective?d. What is it that makes Stella Artois’ premium pricing worth it to consumers?

Individual Assignments

1. Reread the opening section of this chapter on “What is a Price?” Imagine you are considering purchasing a new suit for interviewing. You are considering comparison-shopping for your new suit at Saks Fifth Avenue (high-end department store) and Dillard’s (moderate department store). Discuss the overall differences in “Price” between the two establishments. (Objective 1)

2. What is Everyday Low Pricing? Besides Wal-Mart, what companies do you believe have been able to use this pricing strategy to great success? (Objective 2)

Think-Pair-Share

Consider the following questions, formulate an answer, pair with the student on your right, share your thoughts with one another, and respond to questions from the instructor.

1. What is price? (Objective 1)2. Discuss the role that customer value plays in the determination of price. (Objective 2)3. Explain the difference between value-based, good-value, and value-adding pricing

strategies. (Objective 2)4. What is target-profit pricing? (Objective 3)5. Explain the demand curve. (Objective 3)

Outside Examples



1. Take a look at The Poisoned Pen (http://www.poisonedpen.com/). The Poisoned Pen is a small independent bookstore located in Scottsdale, Arizona. Their motto is “It’s more than a Bookstore, It’s an Experience.” Look around their website. Read the blog by Barbara, the owner. See what authors are scheduled to appear and sign their books. Check out their pricing. Experience them. Discuss The Poisoned Pen’s approach to pricing. How are they able to remain competitive against booksellers such as Amazon or Borders? (Objective 2)

Possible Solution.

After spending some time looking around the website of The Poisoned Pen, it becomes evident that they are certainly not a discount pricing operation. In an industry where it has become normal to find newly released hardback books at 25% to 50% off of the manufacturer’s suggested price, The Poisoned Pen does not discount. But, for their customers, this pricing strategy is a bargain. The Poisoned Pen uses a Value-Based Pricing approach. The prices of their products are set not on what the product costs them, but, rather, on the buyer’s perception of value. Their approach is definitely value-added. They provide a high level of personalized service to their clients, keeping track of what they have previously purchased and making suggestions on what else they may be interested in. Your personal information is kept on file with them allowing a customer to simply call them up and say, “Hi, this is Mike. Would you please send me the new Cussler book?” Additionally, they specialize in signed first editions. This high level of personalized service combined with author signed editions of books is what ensures they are capable of proving high value to their customers. This is value-added pricing at its best.

2. Your text talks about Bang & Olufsen, the high-end consumer electronics producer. You can explore their company and products at http://www.bang-olufsen.com. Take some time to learn about the types of products they offer and find something you would like to own. Use their store locator and find the retailer closest to you. All of their retailers have their own website. Visit one and price the components of interest to you. How can they charge what they charge? (Objective 4)

Possible Solution.

Bang & Olufsen does not sell on price. As a matter of fact, it is rather difficult to find any reference to prices on the websites. As the text points out, they have worked to create a “nonprice” position for B&O products. They build products know for exceptional quality and construction, products that are on the cutting edge, both from a performance and aesthetic perspective. They do not compare their products to any other products, because they believe they have no peer. Since Bang & Olufsen has chosen to compete on non-price variables, decisions about quality, promotion, and distribution become most important.


http://www.bang-olufsen.com/

http://www.poisonedpen.com/


Web Resources

1. http://247.prenhall.comThis is the link to the Prentice Hall support link.

2. http://traderjoes.com/Here is Trader Joe’s homepage. It will be useful to you as you read and think about the opening segment of this chapter.

3. http://www.panerabread.com/Take a look at Panera Bread Co. and examine their pricing strategies.

4. http://www.stagumbrellas.com/This is the home page for Ebrahim Currim & Sons, the manufacturer of Stag umbrella.

5. http://www.ferrariworld.com/FWorld/fw/index.jspExplore Ferrari’s world here. You can learn about their history and cars.

6. http://www.annieblooms.comThis is a great site to learn about how a small independent bookseller can successfully compete with the major chains.


http://www.annieblooms.com/

http://www.ferrariworld.com/FWorld/fw/index.jsp

http://www.stagumbrellas.com/

http://www.panerabread.com/

http://traderjoes.com/

http://247.prenhall.com/

Documents

company case southwest airlines